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Pitt’s Revenge
The SEC chief's corporate cleansing is just what we need.


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Larry Kudlow

It is often said that the stock market is driven by fear and greed. If greed was the dominant psychology of the market’s rise in 1999 and 2000, certainly fear is the watchword for the Panic of ‘02.

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Fear of what? Well, for CEOs and CFOs, fear of a twenty-year jail term is a good place to start. New legislation now pending in Congress could mandate a twenty-year prison term for something as ambiguous as “artifice and fraud,” a legal penalty that could be as wide-bodied as a 350-pound offensive lineman in the NFL.

A second fear factor for top corporate execs is the SEC’s new order that company financial statements must be certified for accuracy and completeness. Harvey Pitt may be the most embattled SEC commissioner in our lifetime. But with this move, he has trumped slow-moving congressional legislation with one of the most draconian new regulations in history. Call it Pitt’s revenge.

Signed under oath, these new written statements must be filed on or shortly after August 14, 2002. They will require CEOs and financial chiefs at 947 large companies to swear “to the best of my knowledge” that their financial statements are accurate. Importantly, these execs could face criminal as well as civil liability if regulators find any problems in their statements. The SEC intends to make the certifications available to the public on its website.

Most top business execs I know would prefer to stay out of jail. So you can bet your bottom dollar — or your last share of WorldCom — that our corporate leaders will err massively on the side of conservative accounting and forecasting for all manner of revenues, expenses, and profits.

Which brings us to a third fear: Investors are hyper-worried that anticipated profits from a rising economy could evaporate because of incredibly cautious accounting by under-the-gun executives. So, despite the fact that industrial production has been climbing for six straight months, verifying that the economy is definitely on the mend, now we’re talking the chance of zippo profits, or even profit declines. That’s what the threat of a jail term can do.

The odd part of this stock-market story is that profits in the second quarter are actually up 8% over last year for 233 of the S&P 500 companies that have already reported. This suggests an average earnings per share of $12.65, compared with last year’s $11.23, for a rise of nearly 13%. But the stock market is off 29% from a year ago and 18% since the SEC’s re-certification announcement of June 28. In other words, nobody in the market believes the latest profit reports because they are SEC non-certified.

While both Republican and Democratic senators keep calling for his resignation, Harvey Pitt himself is determined to cleanse the corporate mind of ethical breakdowns and prosecute any hint of dishonest accounting. Therefore, the next truly credible profit report arrives August 14. Meanwhile, because of jailtime threats, investors will be worried over the prospect of big downward profit revisions.

The famous disconnect between a rising economy and falling stocks cannot possibly be resolved until we hear from the 950 or so firms that will post their newly scrubbed results on the SEC website. And August 14 is just the beginning; company documents will dribble in for several weeks after that date.

As we wait for the new results, it is worth remembering that through ten recessions and ten bear markets since World War II, economic recovery cycles have always delivered higher share prices. Over the long-term, there is no disconnect between the economy and the market. From 1947 through mid-year 2002, a 55-year period, inflation-adjusted economic growth in the U.S. registered a 3.4% average yearly gain. Company profits increased by 3.1% a year in that time. And total returns (including dividends) for the S&P 500 increased near 8.7% annually. Your money doubles about every ten years.

It’s an important lesson. In a free economy such as ours, stock markets are great wealth creators over the long run. Even now, with near zero inflation, rock-bottom interest rates, falling taxes, and surging productivity, a double-dip profits recession is not likely.

Investors who can substitute faith for fear will be handsomely rewarded by investing in stocks. Though the road directly ahead may be filled with large bumps and deep potholes, Harvey Pitt’s systemic corporate cleansing may yet save the system from itself.



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